Late in 2010 a white paper entitled “Can an ETF Collapse?” attracted a great deal of media attention. The paper was published by Bogan Associates, a research firm based in Boston, Massachusetts.

The paper’s authors focused on the fact that some ETFs have a short interest (the number of shares sold short) that is significantly higher than the number of shares outstanding. They deduced that if a large enough redemption occurred in one of these ETFs, it would be left with no net assets. Consequently, remaining investors risked owning a fund with no value, said Bogan.

Fortunately for ETF investors, the Bogan report’s version of events is a myth. Below, we show why.

Can An ETF Have More Shorts Than Shares? Yes!

Is Bogan’s initial claim, that ETFs can exist with more shorts than shares, actually true? At first glance this sounds like an argument for the existence of dark matter. However, even though data on short interest in ETFs is published with a lag, the answer is clearly yes.

In fact high short interest levels in ETFs are not a recent phenomenon.

Since 2006 the level of short interest in IWM (the Russell 2000 ETF) has been an important indication of the level of traders’ pre-positioning ahead of the index’s annual rebalancing, which takes place each June (see exhibit 1).

Market traders typically anticipate the Russell index rebalancing by buying stocks that are expected to join the index. Often, traders use IWM as a hedge when conducting this trade, shorting it to reduce their exposure to overall market movements.

However, too high a level of short interest can indicate that too many traders are anticipating the same outcome. And, paradoxically, a higher level of short interest than shares outstanding for IWM during the run-up to the annual rebalancing has typically suggested that the index trade would go the “wrong way” (the share prices of those stocks expected to join the index would subsequently fall and the price of the stocks exiting the index would rise).

For the purposes of our discussion, however, it’s clear that a short interest ratio exceeding 100% has occurred regularly in the past for a highly popular ETF without anything untoward happening.

Exhibit 1: IWM Short Interest A Signal For The Russell Index Rebalance Performance

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